We finally launched!

Sorry for the long gap since my last post. We've been working hard on the investment research management tool I've been hinting at, and it's finally ready for testing. We've decided to open the test to all comers, so if you are interested, you can create an account at

https://demo.stocknotes.net

I'm posting my investment ideas on the site now, since it has a neat automated tool for publishing private ideas publicly. My latest idea is BTC+, warrants for Community Banker, a SPAC. Check it out and let me know here if you have any comments.

We are calling the product Panorama, and let me give you a quick description of how to use it. The main idea in Panorama is that you can create a list of stocks you've looked at, some in depth, some just for a few minutes. For the stocks you find worth researching in depth, Panorama will allow you to save your notes, spreadsheets, pdfs and other documents online, so they are always accessible anywhere in the world. You can mark which stocks you own and which you'd like to own, and Panorama will tell you when they reach full value or when they are very cheap, through an e-mail alerting service if you choose. And all of your proprietary data is password protected. Good luck and if you have any questions you can reach us at support@stocknotes.net.

Buffett and the Sudan

Much has been written about the recent shareholder vote at Berkshire Hathaway on a proposal for Berkshire to sell it's PetroChina holdings or not, with a stated intent to influence the Chinese government to sell it's oil interests in the Sudan. Warren Buffett did not have to allow this proposal to be voted on, but he did. He opposed it for the following reasons.

1) That Petrochina has no interests in the Sudan. PetroChina is a majority owned subsidary of CNPC, which essentially is an arm of the Chinese government, and CNPC owns and operates the oil interests in the Sudan. Even though they have overlapping boards of directors, CNPC controls PetroChina, not the other way around.

2) Selling PetroChina shares isn't likely to have any affect on the Chinese government. It's unlikely they care who their shareholder base is or what those shareholders say, CNPC controls PetroChina and will do what they want.

3) Even if the previous two arguments were wrong, having the CNPC leave the Sudan doesn't change anything, in fact it could potentially make things worse. Those oil assets aren't going anywhere, the CNPC will be forced to sell them at a fire sale price to another company (which will pay the same royalties to the government) or to the government of the Sudan, which will enrich those responsible for the genocide even more.

The vote was held, the two retired professors were given their say, and the proposal was voted down 98% to 2%. Obviously the Berkshire shareholder base agreed with Warren on this issue. How to solve the problems in Darfur is an issue that reasonable people can differ on, but I haven't encountered anyone who disagrees that something must be done. I believe that if we truly care about ending the genocide, we shouldn't advocate futile and wasteful symbolic acts. We have a duty to lobby for a truly effective policies that will absolutely end the genocide. Frankly, I think Clinton showed us the right approach in Bosnia.

I'm writing today because in all the coverage I've read on Buffett and the disvestiture vote, I found none to be balanced or complete. Specifically, I've never read any discussion or explanation of Buffett's key third point. But as a participant in the financial markets you come to expect this from new stories. They are written quickly by journalists under a deadline who might not have a deep understanding of business. But I do expect a little more from columnists who have the time to research and write well balanced columns.

Sadly, Marketwatch's David Weidner isn't one of them. In this column, he writes several things that are patently untrue, and links to a previous column filled with similar falsehoods.

Specifically one of his first paragraphs.

"Buffett and his followers believe it doesn't matter how you make your money, as long as you give it away when you're dead. Embrace businesses such as PetroChina Co. which arguably is aiding the genocide in Darfur by investing in the Sudanese government's oil explorations -- or risk that extra penny a share in profit."

As Buffett has pointed out, PetroChina has made no investment in the Sudan. And Buffett has never been quoted as saying it doesn't matter how you make your money. In fact, Buffett has been quoted many times as saying there are businesses he'd never invest in, no matter how profitable, because of moral reasons.

"The PetroChina subsidiary in Sudan pays the government for the right to produce oil there"

Once again, PetroChina makes no payments in the Sudan, has no business in the Sudan, well you get it. After a series of similar misrepresentations, David finishes by saying

"Hey, if you could make a few bucks dealing with someone you know is helping hide a serial killer, why say anything? It probably wouldn't help, right?"

This is what you call a straw man argument, and it's an over the top doozy. Buffett isn't making anything in the Sudan since PetroChina generates no revenues and has no business there. There is a more nuanced argument about Buffett's responsibilities, but not one that David is apparently able to make.

The fact that David could release this column says a great deal about MarketWatch's editorial control and fact checking. As a big fan of Herb Greenberg, it almost makes me wonder about his columns. But at least Herb references actual facts when he makes his arguments, I can't ever recall him spewing allegations without providing any support for them.

Dave Weidner apparently has been perturbed at Buffett's behavior for a while. His earlier column attacks Buffett, for of all things, the manner in which he's decided to give away his fortune to charity.

"The 75-year-old is giving away his wealth? Yes, but slowly, over time. He is not putting his or his family's welfare at risk and will not miss any meals, even if he chooses only to famously dine on his burgers and Cherry Coke."

Buffett doesn't own a ranch in Montana, a large yacht, and lives fairly frugally. That part is true. David is arguing that Buffett should have given it all away immediately (even though he's not spending it). Of course, had Warren given away all his wealth in 1970 during his "retirement", the world of philanthropy would be $20M better off. Instead he waited, and we should all be grateful he did. Not only is he nominally giving away nearly $40B, but the amount will grow as he continues to build wealth. It's not unreasonable to expect the final amount to approach $100B. All because he worked hard, and will continue working hard, at building a large estate, not for himself, but for the benefit of his charitable foundations.

After that David attacks Buffett for owning tobacco companies. "Long after the public turned on smoking and health, Buffett infamously explained his investment in the tobacco business: "It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty.""

David's actually using a quote of Buffett taken out of context, where Buffett is quoting another person to make the ironic point that it's a great business, but is it one you want to own? Berkshire directly owns no tobacco stocks, and hasn't for a very long time. Buffett actually divested of his shares in RJR over 25 years ago!

More recently he was offered another opportunity to get back in the business.

"Warren Buffett, the chairman of Berkshire Hathaway, remarked to the shareholders in 1997 that he was offered the chance to buy a company that manufactures chewing tobacco. He and Charlie Munger, his vice chairman, knew that it was going to do very well and subsequently it has. They did not, however, go through with the purchase. As Buffett explained, "We sat in a hotel in Memphis in the lobby and talked about it and decided that we didn't want to do it."'

Since chewing tobacco is dramatically safer than cigarettes, I actually think he should have done the investment.

Berkshire's only tobacco holdings as of this writing is a small amount of shares owned by a subsidary insurance company, Gen Re. It's not a significant holding, and it's unlikely that Buffett even manages this portfolio, just as he does not manage GEICO's portfolio (Lou Simpson does).

In the rest of the column, David continues to make wild allegations about Buffett's "ruthlessness" without providing foundation (I.e. Buffett legally canceled a contract). Too many to rebut in this space, I'll just finish with his most egregious effort. Incredulously, David takes Buffett to task for not lying or stonewalling investigators during the AIG investigation. He paints it as Buffett "selling out" his "friend" Hank Greenburg, even though Hank is took the fifth and was fired for his actions. By this point, you just have to wonder what David Weidner 's definition of ethical behavior is. I guess, clearly, that even he doesn't know.

Quick Update On Kaiser

Reverse split price is $36 according to todays proxy. We'll see if any arbitrage affects things, the price hasn't moved.

Only the frontier is efficient?

I just got off the phone with the trust advisors running a trust that I'm an eventual beneficiary of. It's not a very large trust, but it's important, as my mother relies on it for much of her income. The advisers had just put together a super duper plan to manage the trust based on the concepts of the "efficient frontier". In case you don't know, the "efficient frontier" is a portfolio management concept that sprang from the efficient market theory. The idea is to allocate a portfolio across groups of uncorrelated investments to reduce volatility as much as possible without giving up much in the way of long term returns.

To do this in the trust, they overweighted large cap equities 3-1 over small caps and 2.5-1 over mid caps. They dabbled in international real estate as well as domestic, and even threw in a small (4%) proportion of commodities. The entire portfolio is is adorned with a big fat Sharpe ratio, telling you proudly how well it plans to reduce your volatility.

When I asked why the overweight in large caps, they rattled off about computer models, macro economic predictions, and recent small cap out performance. I asked why commodities then, since they are on a two year period of out performance, have no intrinsic value and are just a playground for speculators. Inflation they mumbled. Lastly I asked why almost all of the equity funds they recommended are actively managed. They responded that their bank does intensive work to vet mutual fund managers and choose only those who will beat the market.

So this is what it comes down to. The EMT, Modern Portfolio Theory and the efficient frontier have permeated large money management organizations. They've adopted the parts they like (putting together complex portfolio allocations) and ignored the parts they don't like (that you can't time the market, predict the future, and you can't pick out performing mutual funds), and cover it with a dollop of MPT jargon to dazzle the client.

I wanted to ask them how they could throw out the foundation of Modern Portfolio Theory and still use the remnants left literally hanging in space without support, but it would have been unfair. They weren't bad guys, just salesmen, selling what their company had given them to sell. I just smiled over the phone, thanked them for their time and asked again to increase the yield as much as they could. Mother isn't getting any younger.

Kaiser Group going private?

KGHI just released their 2006 10k. It contained the following interesting tidbit.

"Proceeding with a 1-for-20 reverse split requires that we amend the Company’s Certificate of Incorporation, which requires stockholder approval. The Board adopted resolutions at a special meeting held on March 19, 2007, which, among other things, set forth the proposed amendment, determined that the reverse split is advisable, and called for submission of the amendment for approval by the Company’s stockholders at the Annual Meeting to be held on May 30, 2007."

It's not surprising that KGHI wants to go private as they have only four employees and it should save a significant amount of administration costs. Is this a good thing for investors? I think so. Once the company officially announces the reverse split they'll affix a price to each fractional share. For example, if you own 23 shares, you'll get one new share plus cash for the extra three "fractional" shares. Current book value is about $36.92 per share, so it's reasonable to expect the price they'll set to buy back fractional shares to be near book value. This won't drive the price up to book value, but there will be some arbitrage occuring as small investors try to buy 19 shares in each of their accounts to take advantage of the discount knowing they'll be cashed out in full.

For example if the cash out price is $37, then I would expect KGHI to start trading over $30, possibly closer to $34. Of course this only benefits those who want to sell the stock pre-split, and there may not be enough volume to sell a large number of shares. After the split I still expect the new shares to trade, but with less information released by management and even less liquidity (if that's possible). Holding may be still be a good investment as I believe the controlling shareholders still see more value in KGHI, but I have no idea how long it will take to unearth it.

Good luck, which ever path you decide to take here.

Hurray For Naked Shorting!

After thinking more about the melt-down at Novastar, I realized the catastrophe had some obvious heroes. The shorts, and not just the "legal" shorts, but also the evil, illegal, conspiring naked shorts. According to "Bob O'Brien" and others, a conspiracy by naked shorts kept Novastar's stock price substantially lower than it should have been the last few years. That means those secretive "Sith Lords" (as OSTK CEO Patrick Byrne calls them) helped save Novastar's investors millions upon millions of dollars during the meltdown.

Think about it. One of the few events worse than having a $30 stock plummet to $8 is owning a $60 stock that plummets to $8. That lower purchase price is the difference between having 26% of your investment left, vs. only 13%. So NFI investors may have twice as much of their NFI invesment left in todays world, than they would in a world where illegitimate "bashers" didn't sniff out Novastars overstated financials and find any means possible to short it.

So repeat after me. Hip, hip hoorary for naked shorts and naked shorting!!!!

"Novastar" means it's collapsing and exploding

Herb Greenberg (not the MLB hall of famer Hank, whom I often confuse Herb with because they both hit so hard) wrote about the collapse of Novastar Thursday (trading at $27 in January, as high as $38 last spring, closed at $8.48 yesterday). The Bob O'Brien character is the same guy who supplied Patrick Byrne information about the "naked shorting" conspiracy.

" Much of the attempted deconstruction of criticism would spill over to a Web site run by an anonymous message board poster, who went by the name Bob O'Brien and who by then had also become pals with CEO Patrick Byrne - himself having gone on a "jihad" against critics of his own company. Both teamed up to also attack an illegal form of short-selling.

In spring 2005, O'Brien went so far as to post the address and names of the wife and son of one prominent short-seller of NovaStar in a message board post, with the tag line, "This is coming up on game over-time. Figure it out. Your playbook is known." In another post he wrote, "Anyone know Herb's wife's name, and his middle initial?"
...
The bravado was gone Tuesday in the wake of NovaStar's disclosures. "I have been body-slammed by this," wrote the anonymous poster, who has been identified by the New York Post as a former used-Cat Scan machine salesman named Phil Saunders. "Many of my friends are devastated by this. Some of my relatives, too. Personally, you bet. Very expensive lesson: Don't bet more than you can afford to lose. And don't bluff. I will not be buying anymore stocks in the U.S. markets, that's for sure. I'm quite done now. This casino has lost its allure."

I looked at Novastar back a couple years ago when some supposed "value" guys were trumpeting it as the next big thing. The yield was very juicy, at the time I think the dividend was $5 and the stock $30. But I could not understand it's financials, how it securitized loans and accounted for them, and essentially gave up. The critics said that the earnings were manufactured, that Novastar was using their REIT status and the tax code to front load earnings from the sale of their mortgages. As a REIT it was required to pay out 95% of these "earnings" as dividends. Since they hadn't recieved these "earnings" yet, Novastar had to borrow money to pay it's dividends and hope their front loaded earnings always turned out as estimated. Well today we know that they didn't.

Novastar illustrates two important principles. The first is, if something seems too good to be true, then be very, very, careful. Paying out illusionary dividends is a time tested marketing technique for attracting suckers to overpay for a stock. You can see it occasionally in the closed end fund business. Most close end funds trade at somewhere between a small and large discount to their net asset value (NAV). Some enterprising fund managers have learned they if they pay out very high large dividends their fund will begin to trade at a large premium to NAV. Where does the excess yield come from? By return of capital. Most investors don't understand why the fund is yielding 13%, they jump in thinking they've found a magic investment that will afford them high retirement income. As the NAV declines over time, they figure it out too late that it was their own savings they were spending.

The second principle is one of the bedrocks of value investing. If you can't understand it, don't invest in it. I couldn't understand Novastar, so I passed. It's clear now the "value investors" who were smitten by it's high yield never really understood how that yield was generated, and the risk Novastar took in writing those loans. At the time I figured I must just be too lazy to figure Novastar out. But because there is some virtue in focusing efforts on things that are easy to understand, my results were much better than I would have gained from Novastar even had it not collapsed. As Buffett says, figure out your circle of competence, and stick within that circle. You'll do much better there.

Still accepting expressions of interest

If you read about "The best way to track investment ideas, ever?" and are wondering where we are at, we are getting closer. I've been using the software and all I can say is I'm incredibly pleased and excited. I expect we will start outside testing within another month or two. Remember if you'd like to test the software or just be on the mailing list for when it's ready, send your name and e-mail address to "stocknotesinfo@gmail.com", and we'll let you know.

Sometimes you get what you pay for

Bancinsurance Corporation ( BCIS.pk ) is cheap. Hella cheap. Maybe you've also seen it come up on one of your screens. At $6 it's trading around 4.5x earnings, and slightly under tangible book value. It has an active insurance business that has been solidly profitable.

So why is it so cheap? Well I took a quick pass through it's latest 10Q to find out. First, it went through a period a couple years ago where it expanded into underwriting bail & immigration bonds and had to take some big writeoffs before they shut it down. It also lost an auditor during that period and had to refile financials to clean up the mess. But it's cheap for some other reasons as well.

Let's figure out what their real earning are. First, they sold a small publishing operation they had that did governmental and legal publishing. This is adding 50 cents per share (pre tax $2.5M "Net realized gain on sale of affiliate") to 2006 earnings. They've also taken $952k in losses from their discontinued bail bonds programs that probably won't recure in the future. This turns the 9 month after tax profit of $5M into something closer to $4M, or about $5.3M annualized.

Free cash flow appears higher than earnings with an annualized benefit of about $400k in depreciation over capex costs. So our P/FCF ratio is about 5.3. Still pretty cheap. Another way to look at it is to invert the free cash flow ratio to get a yield. That's how we would look at it were we to buy all the shares at $6, and distributed all of the free cash flow to ourselves. In that case, our investment would yield close to 19% per year. As Borat would say "very nice!".

But we aren't the owners, so we don't have any say on whether that free cash flow will be returned to us, or reinvested at a good rate. So how likely is it that the current management would do that?

That's where we start to find some hair. Let's start with the positives, Si Sokol and his family own over 50% of BCIS. It's nice to have a huge ownership stake in the hands of someone, because this should mean they'll ensure that profits are reinvested well, or returned to shareholders if they can't. But their track record isn't so good. They had majority control when that huge mistake was made with bail bonds. And in the 10Q, I find out than in only 9 months the company diluted shareholders 5% distributing stock options to employees. That's a huge level of dilution, if they did this annually it would reduce that juicy 19% yield to 14% in one fell swoop.

Let's move on to the remaining insurance business. Another red flag pops up as it's revenues declined almost 10% in the first 9 months of 2006 compared to 2005, primarily because they lost an agent. That's not the sign of a strong business with competitive barriers (a moat). Also, their combined ratio has increased lately to over 100%. That's not good.

For those who don't know what a combined ratio is, it's a measure of how profitably an insurance company is writing business. If the ratio is below 100%, it means the insurer is writing profitable policies. If it's above 100% it means they are losing money on each policy they write. In many cases it's okay to write at break even or even a little above 100% because insurance companies can make up the losses by investing the customers premiums and earning investment returns. BankInsurance has about $50M invested out of customer premiums, and is earning about $3.6M annually in interest. This means they could run their $50M in annual premiums at a 107% combined ratio and break even. Running at 100% would only give them about 40 cents per share in earnings. So they need to run below 100% for this business to be significantly profitable.

The good news is part of the cause of this last quarter increase in combined ratio is writeoffs from the defunct bail bonds business. Without it, the combined ratio would have been 95%, good, but still higher than last years 89%. But how accurate are their loss reserves? The biggest problem with valuing an insurance company is that management can have the ability to defer losses, and make the underwriting ratios look healthier than they really is. The strongest defense is a solid management team with impeccable ethics, and I don't yet know if we have that here.

At first glance BCIS seems to carry excess cash on the balance sheet, but when I look closer I see they are carrying 17M in expensive debt. This is probably a requirement for their credit rating, but carrying debt means that they aren't as well capitalized as one would hope. I don't know how much they need to carry, so one of my next tasks would be to analyse this and see if there is excess cash that shareholders might be able to see in a dividend down the road.

So to sum up, I would describe BCIS as a fair business at a good price, as opposed to the good business at a fair price we'd prefer. It's not a "cigar butt" a company super cheap but heading out of business, this is just a very cheap business that is in a slight decline without any clear tangible competitive advantages. Right now I don't have a good read on the management and ownership's goals and track records, and since I haven't read a 10K, their long term performance is unclear. I'll be reading that next and if it sheds any light, I'll post an update.

One bankruptcy isn't more efficient than two

Rumours recently swirled that Chrysler was in talks to be acquired by GM. Now while this makes a certain sense for Mercedes, er Daimler-Benz, which has finally come to the realization that it has to unload this horrible, horrible acquisition, it doesn't make any sense for GM.

This page pretty much summarizes GM and Chrysler's problems. Toyota is eating their lunch not by paying their workers poorly, on the contrary they are paying well in excess of typical manufacturing wages, about $30 per hour.. The difference is that the UAW contracts that U.S. automakers are under impose huge legacy costs, including a jobs bank to pay employees not to work, very lucrative medical plans, and very lucrative pensions.

And it can be argued, that the UAW has stood in the way of U.S. auto makers using their workers most efficiently, reflected in the extra hours it takes to build U.S. cars. The UAW has been so "successful" that they've killed hundreds of thousands of their own jobs, and the pension and medical costs for retired auto workers is about to kill GM, Ford, and Chrysler. Quite simply, the U.S. automakers business model doesn't work, and won't ever be competitive without a substantial change in their labor contracts.

The auto makers have one shot to fix this in their next contract negotiation with the UAW. It seems clear they will get some compromises, even the UAW realises how close to the brink the big three are. But combining GM and Chrysler before those negotiations would be the worst possible mistake. It would create a single entity with deeper pockets and less leverage against the UAW, it that could be shut down by union fiat in any disagreement. This is why Daimler must get rid of Chrysler now, because the UAW will never compromise if it thinks ownership has deep pockets. This is why GM's leadership made a huge mistake in selling GMAC instead of spinning it off, they put more cash back into their dying business so the UAW would have less incentive to compromise.

The clear solution is a bankrupcty filing by each of the big three. A bankruptcy judge is likely to cancel the UAW contracts and make Ford, GM, and Chrysler competitive again. And current equity might even remain, and possibly even increase in value.

But so far we've seen no inclination by management to do the smart thing. Until then, an investment in a domestic auto maker is foolhardy. The automakers may have bounce backs during strong economic years, but the end result is inevitable. By the time the next management team decides to use bankruptcy court, it's unlikely common shareholders will have anything left.

My Russian Roulette Pick Of The Day

Like big, big, prizes? Unhappy with "moderate" returns like 10%, 20%, or even 30% per year? Ever hold a firecracker in your hand until the last second, because you're willing to take a risk? If you are ready to swing for the fences and don't mind a few catcalls from the crowd if you strike out and end up on your ass in the dirt, this idea is for you.

Three Five Systems (TFSIQ, on the pinksheets) is a local (Arizona) public company that entered bankruptcy about a year and a half ago to clean up a few issues with its subsidaries and (hopefully) pay out the remaining cash to shareholders. I got into this over a year ago, traded it several times for a profit, and then ended up getting stuck bad as it declined from 30 cents to 8. Right now it's trading between 10-11 cents.

There are two problems with investing in companies in bankruptcy. First is that typically, the common shares are worthless. Second is that if they aren't, it's very difficult to determine what they might be worth, esp. for the amateur investor. I invested in TFSIQ because I was convinced that this was one of those rare exceptions that might be worth something, and because I thought I had a good read on what it's worth. As of early 2006 it looked reasonable that Three Five would be able to pay out 32 cents and possibly more, given a bankruptcy plan with a shareholder equity of 6.9M for 21.8M shares (the 8k of November 7, 2006 that announces the plan's approval contains contains all the details in it's addendum). Despite the approval of this plan, things have gotten somewhat murkier since the plan was created in early 2006. The last operating report I have contains a balance sheet from September 10th with a shareholders equity of 5.179M, or 24 cents per share.

Specifically, Three Five is in disputes with several parties, and the outcome of those disputes will determine our end value, which will range from zero all the way up to 24 cents, or even possibly 32 cents. The biggest problem is with a subsidiary. To quote from the September operating report

"TFS has an investment of $2 million in TFS-DI, a wholly owned subsidiary, which is subject to litigation and compromise. TFS has filed suit in U S Bankruptcy Court against a party to a contract alleging among other things breach of contract. The defendant has filed a counter claim for $5.5 million which TFS denies. However, TFS and TFS-DI together have recorded liabilities of $4.5 million for note payments to and inventory purchases from the defendant. The outcome of this litigation cannot be predicted, and could materially affect the final cash distributions."

They also have disputes with their local landlord, and a suit (against Topsearch Printed Circuits Ltd. and Avocent Corporation) that might bring in additional upside. More details can be found on Pacer (Arizona Bankruptcy court, case #2:05-bk-17104) as well as in their SEC filings and their lawyers web site. If you don't have a pacer account, it's highly recommended as it will allow you to read all the legal filings on virtually any case, for a fairly reasonable price.

To keep the blog short, I'm not going to go into any more detail, so let me finish by summation. For 11 cents right it seems you can buy shares that might be worth more than twice as much, or nothing, later this year. I believe it's more likely they'll be worth something than nothing, so I'm holding my shares for now. But given the high risk level here I'd counsel caution and doing your own research. My rule of thumb for high risk positions is to limit each to 5% of my portfolio. If you decide to invest here, I'd caution you to do something similar.

If Three Five Systems still sounds interesting (and if it does you might be as crazy as I), have fun and enjoy the wild, wild, world of bankruptcy investing. And let me know if you find anything interesting.

Back in the days of dinosaurs

Value was so compelling that even a caveman could recognize it.

Moody's writeup from 1951, thanks to Shai Dardashti

So how did Buffett find this company? My guess is that it's the same story then as today, effort. He read everything, three or four newspapers a day, and every page for every stock in Moody's (and later Valueline), until he finally found something this stinking obvious.

So if you like to complain about how few good ideas are out there, compare your effort to Warren's. I'll bet you come up a little short in the comparison.

CEO don't control the stock price, or do they?

I've been wanting to comment on Robert Nardelli's resignation as CEO of Home Depot for some weeks. Actually not the resignation per se, but on one prevalent theme that media commentators have used to explain it. I'll pick on Alan Murray of the Wall Street Journal to start, quoting from his comments on Jan. 4th.

"Some of Mr. Nardelli's numbers were hard to argue with. In six years on the job, he doubled Home Depot's sales and more than doubled its earnings." Mr. Murray then goes on to explain that it was Nardelli's lack of political skills that doomed him more so than performance. To give Mr. Murray credit, he also mentions other performance factors that might have hurt Nardelli as well, including poor stock price returns, and pushing Home Depot into the "low margin wholesale business".

Matt Koppenheffer of the Motley Fool says it more directly. "Had Home Depot's stock price headed up and to the right during Nardelli's term, investors might very well be patting themselves on the back for money well spent on a great executive." Essentially, because the market stubbornly refused to reward Home Depot shareholders for Nardelli's great management, he was forced out, with his only real sin being his arrogance.

Is Home Depot really a better company for Nardelli's efforts? Let's look at the numbers. Nardelli is credited with doubling earnings and sales in six years, a compound annualized growth rate of about 12% per year. But in the single year before Nardelli took over, Home Depot grew sales 26% and earnings almost 50%. At that pace sales would double every three years, not six.

So it's a myth that "Bob Nardelli doubled sales at Home Depot", those sales were doubling whether he was there or not. Sales actually grew much slower under his watch. That's not necessarily bad, Home Depot was growing fast enough that it would soon run into saturation problems. But almost any CEO running Home Depot would have come close to doubling sales, so why credit Bob for that?

And Bob "bought" some of this growth by expanding into areas outside of the Home Depot's greatest area of expertise, retail, into wholesale distribution. You would think this lack of focus could hurt retail execution, and it did. Even worse was Bob's approach to customer service. Nardelli improved margins by hiring less skilled and dedicated employees on the front lines, i.e. by paying less. But those employees were a huge part of the Home Depot brand, which is what made Home Depot successful to begin with. That brand created those high margins, and when Bob reduced that service, he angered his best customers and gave a huge gift to his biggest competitor, Lowes. It's very clear that retail performance, the most important criteria for measuring the CEO of Home Depot, declined under Nardelli's tenure. He as much admitted this when he attempted to stop reporting same store sales in his final year.

Nardelli's decisions made Home Depot's results look better in the short run, but the short run is over. So was Bob fired over anger at his pay package, or his arrogance at the last shareholders meeting? Or was it because Bob's "success" appears to have been a short term house of cards built on buying revenues and under-investment in their core business?

CEO's can't directly control the stock price in the short run. But the key decisions they make can create or destroy large amounts of shareholder value, and will eventually be reflected in the stock price. In Bob's case, I think the stock price has clearly reflected how the market perceives his "contributions".

It's coming. If you haven't signed up for the greatest product ever concieved for managing your investment ideas, now is the time. Just drop me a line at stocknotesinfo@gmail.com, and tell me if you want to test, or just to be notified when we are ready.

thanks,
Randy

Arbitrage opportunities at Star Maritime?

Star Maritime (SEA) is a "blank check" company that seems to offer an interesting "risk free" opportunities that I liken almost to an arbitrage. "Blank check" companies are interesting vehicles that have gained a bit of popularity recently. A blank check company is created through an IPO to raise funds for a management team to search for a potential acquisition. The IPO investors receuve not only shares, but typically also warrants that are exercisable if the acquisition is approved. The shareholders also receive some interesting security. Their funds are held in trust, and management is given only a limited time to find an acquisition. If they don't find one by their deadline, or can't get their choice approved by shareholders, the company is forcibly liquidated and the common shareholders get all the trust cash plus interest returned to them. Even if the deal is approved, the company has to buy back the shares of any dissenting shareholders at a redemption price.

And in the case of SEA, the normal blank check arrangement is even more advantageous to shareholders. SEA sold 20M units in it's IPO (a unit being one share and one warrant exercisable at $8) for $10 per unit. But management bought over 1M units at a cost of over $10M, and have agreed to forfeit those shares if the acquisition is not approved (and the underwriters also have to forfeit their fees). And management only has until the end of June to get a deal approved. So how much would a common shareholder receive in a liquidation scenario?

There are two slightly different scenarios, the first is if the acquisition is voted down, all common shareholders (except management) receive the trust proceeds. The second is the deal goes through but you elect to redeem your shares. Let's start with the first.

As of Sept. 30th, there is 192.7M in trust, and by my calculations, 18.9M shares eligible for distributions, or $10.22. The trust is netting about .34% in quarterly interest after tax/expenses, so on July 1st the distribution should be around $10.32.

In the second scenario, you have the right even in an successful vote to redeem your shares for $9.80 (the $10 minus underwriters fees) plus interest, basically a 20 cent per share difference from liquidation. So I estimate a value of about $10.12 on July 1.

SEA announced their deal this week. The common didn't move, it's been trading around $9.90, so essentially you can get either a 2.2% gain if your shares are redeemed ( 5.1% annualized) or if the deal is voted down, you'll get a 4.2% gain (9.9% annualized). Doesn't sound like much does it? But these gains are essentially risk free, so it looks like SEA is offering you a money market rate in the worst case scenario, with a kicker that doubles your returns if the deal is voted down. And if you can get the shares cheaper (I think they may have hit $9.85 briefly on Friday) returns are even better.

But wait, there is still more upside to the common! By holding common shares you get a free "call option" on any price increase in the common until the deal is voted on. For example, if SEA trades at $11 next week, you can sell and reap some nice short term profits. If it drops to $8, you simply wait until redemption to get $10+. You keep all upside, with no downside!

Now the negatives. I'm not super impressed with the deal and so far neither is the market, but there is still plenty of time left until a vote happens where you might be able to profit from upswings in the price. We have the risk that management files for an extension and doesn't get a vote done until late this year or early next. If that happens your annualized returns in these scenarios decline, though interest continues to accumulate and you get a longer "call option" for any possible price spike.

I've been told that 90% of these blank check deals end up getting approved. I don't know how true that is, it sounds extraordinary because the typical deal requires 80%+ shareholder approval. And SEA is a bit special, they only need 67% shareholder approval, but it still sounds like a difficult hill to climb.

So I can imagine what some of you are thinking right now. "Okay, Randy, sounds like an interesting set of circumstances, but the returns aren't that great. I'm a swing for the fences guy, willing to take big risks for big rewards. What have you got for me?".

Okay, you want some real upside mixed with some real danger? Look at warrants, SEA+ (SEA-WT on Yahoo). They are trading around $1.40 (unfortunately up 20 cents over the previous two days). These warrants have a strike price of $8, so they should be worth $1.90 or more. But they aren't there yet due to two factors, first that the warrants will be worthless if the deal is voted down, and even if the deal is approved the stock may decline sharply afterwards. IIf this deal is approved, the warrants should be worth more than the stock price minus $8, because they are essentially very long term (2.5 years) call options. The value of this long life span means that if the deal is approved they should trade substantially above the price imputed by the stock price. For example, if the common trades at $10 post deal, I would not be surprised to see the warrants trade above $2.50. Their only downside is the warrant's maximum value is capped around the mid six dollar range, as the company has a buyback right when the stock price trades above $14.25 for 20 out of 30 days.

And this isn't an investment you can take a large direct position. So this is where the "arbitrage" came into play. To reduce risk, I bought the common in a ratio with the warrants, so if the deal is voted down I would make a little money on the common to offset the warrants going to zero. And if the deal is approved, I win on both.

Unfortunately I bought my warrants at 80 cents pre-deal, but sold them at $1.20 as soon as the deal was announced because I didn't really think through how valuable the long term call the warrants provided was. As usual, the price you pay will determine your long term return, so getting either the common or warrants cheaply will definitely make these opportunities more attractive. Right now I own only the common, and won't buy more warrants unless they drop back below $1.20, but you need to make your own determination of what you think a reasonable entry point would be.

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Nicholas Financial (NICK)

Note: I originally posted a longer version of this write-up on ValueInvestorsClub.com, Nicholas is one of my favorite companies and is currently one of my largest positions.

How much would you pay for a company that’s grown same quarter revenues and earnings for 65 out of it’s last 66 quarters? That’s grown EPS from 12 cents per share to $1.08 per share over the last ten years (23.6% annualized). A quality company with solid financials built solely through organic growth, (no rollup), with at least another decade of strong growth ahead in the U.S. market along. I understand, you’re a bargain type guy, and you don’t like to overpay for anything, even your wife’s engagement present. So how about if Mr. Market puts this hot little number on sale, just for a short time, at a little less than 11 times reported TTM earnings? Not interesting enough? What if earnings may be substantially understated? Nicholas Financial exists in the toughest part of the sub-prime auto lending business, and has a unique “hands on” approach that is responsible for high profitability and low loss rates with very low credit score clients. As opposed to other (mostly larger) lenders that centrally automate their approval and collection systems with a focus on maximizing loan productivity, Nicholas handles all clients through local branch offices, in order to get to know them more closely. This means the Nicholas office is close by when clients need to make payments, new applications, and most importantly, when collections are necessary, which helps reduce losses. Competitors use credit scoring as the main determinant of credit risk, allowing their central offices to cost-effectively process high volumes of loan applications. Nicholas feels credit scoring alone is not the most accurate gauge of individual client risk as two clients with identical credit ratings can offer much different risk levels. Nicholas to measure risk through factors that supplement raw credit scores, such as income level, stability, “life” trend, etc. This allows NICK to “cherry pick” clients who have lower risk than credit scores alone would indicate. Even then, Nicholas turns down 85% of potential clients. One of the most attractive qualities of Nicholas is that they do not securitize their loans. This makes their balance sheet clean and easy to understand, and contributes to their quality of earnings. By not securitizing, they actually take long term ownership of their loans. This provides a strong incentive to underwrite conservatively. Because of this, accounting is also conservative, loan discounts are kept as loss reserves and aren’t recognized until the pool is liquidated or the pool is determined to have excess reserves. Leverage is very low (1.35-1 Debt to Equity). Historically the ratio has been higher but a secondary offering in 2004 substantially increased equity. So the risk in the balance sheet revolves around the quality of loan reserves, and the fact it is borrowing short-term, to loan longer term. Since I believe the reserves are strong, and the balance sheet is so lightly leveraged, I see both risks as limited or manageable. The lower leverage since 2004 has had the effect of lowering ROE, which has declined into the 17% range since the secondary. From a conversation in early 2006, management expects the debt to equity ratio to increase as they grow and add more loans, but to stay under 2.5-1 for the next three years. They feel comfortable with any ratio of 3.5-1 or below. Nicholas’ real competitive threat is irrational pricing in the market. The sub prime financial business has gone through irrational pricing periods, until there is a shakeout and some firms go under. This has not happened since 1996-98 when cheap public money flooded the segment. So far, today’s competitors are more rational about pricing. If pricing turns unreasonable, Nicholas has been disciplined enough in the past to give up bad business rather than lose underwriting discipline. Evidence of this is found in 1997, revenues grew only 10% and profits 20% during a period of irrational price competition. The Opportunity: On Nov 2nd, NICK reported disappointing earnings (by it’s standards) in it’s second quarter. Net income only increased 10% year over year, and was actually down over first quarter (27 cents vs 29 cents). In response, the stock declined to the low $11 range, and only recovered a little bit since. A variety of factors are squeezing their results. Borrowing costs are up a half percent, while loan rates are static. Write-offs and charge-offs have increased. NICK has benefited in the past from a rosy economic climate, and it appears to be in the worsening part of the cycle. Finance receivables have only increased 15% year over year, and operating costs are up slightly proportionately. This leads me to suspect that several recently opened branches aren’t up to speed yet and this may be a drag on quarterly comparisons. The question to ask, has anything material damaged their business? I don’t believe so. The key number for me is that 15% growth in finance receivables. Even 15% per year is still excellent, and justifies a much higher PE ratio than it's currently trading at. There are no real limits to their growth at this stage, with many more states to expand into, as well as more markets in current states. My belief is that we may have to deal with some slower growth in the short run if credit losses are higher, but in the long run earnings will keep up with financial receivables growth. Even if EPS growth over the next ten years averages 15% per year, NICK would deserve a much higher PE ratio than 11, I’d think closer to 20. So right now I believe it’s trading at quite a discount to intrinsic value.